Keep Your Eye on Italy

Earlier this month we reported here (“Brexit Vote: Italy Hardest Hit?“) about how Italy was the nation to watch in the aftermath of Brexit, as it had the weakest financial profile among EU nations after Greece. Tomorrow Italy will report the results of its “stress tests” of its banks, and if the results are as dismal as expected, it may trigger the next Eurozone political crisis, and the next chapter in the inevitable unraveling of the EU.

One of my favorite economists, Steve Hanke of Johns Hopkins and the Cato Institute (we spent a pleasant day together at a conference in Warsaw several years back), picks up the story this morning:

[Brexit] also poured fuel on a simmering Italian fire — a fire that could result in an Italian, as well as a Eurozone, doomsday scenario.

In anticipation of poor results from the Italian banks’ stress tests (which will be reported on July 29th), Italy’s Prime Minister, Matteo Renzi, has indicated that his government will unilaterally pump billions of euros into Italy’s troubled banks to recapitalize them. There is a problem with this approach: it is not allowed under new EU rules. These rules require that bank bondholders take losses (a bail-in) before government bailout money can be deployed. But, in Italy, a big chunk of bank debt (bonds) is held by retail investors. These retail investors vote in large numbers. So, the EU bail-in regulation, if invoked, will certainly put Renzi’s neck on the chopping block. And that will come sooner rather than later because the Prime Minister has called for a referendum on Italy’s constitution in October and stated that he’ll resign if the referendum is voted down.

If, following the stress tests, holders of Italian bank debt are required to bail-in banks, there will most certainly be a strong backlash that will not only kill Renzi’s referendum but also his government. That would most likely put the Five Star Movement in the saddle. The Movement is already surging, winning control of important local governments in Rome and Turin. This populist-left movement wants to exit the Eurozone. If you think Brexit was big, such a scenario would not only spell doomsday for Renzi but also probably for the euro.

There’s more at the complete link, but special note should be made of this chart Steve produced of the sharp increase in bad loans on the books of Italian banks:

Hanke chart copy

If the banks and the government are worried, it seems word hasn’t gotten out to Italians in general, as these charts from The Daily Shot (free subscription) show:

Italy Confidence copy

Looks like Italians could be in for a rude shock.